UAL: the challenge of catching up with Delta and American December 2013

2013 was supposed to be a strong recovery year for United Continental (UAL). Having fixed the IT and other integration issues that plagued it in 2012, this year UAL had expected to start showing some merger benefits and narrowing the profit margin gap with competitors.

But that has not happened. UAL has continued to underperform its peers in terms of RASM and profit margins. The margin differentials have widened considerably in recent months. In the third quarter, when Delta increased its operating margin from the year-earlier 14.7% to 15.9% and AMR more than doubled its margin from 4.1% to 10.4%, UAL saw its margin decline slightly from 7.2% to 7%.

It is now more than three years since United and Continental completed their merger in October 2010. The disastrous IT/reservations switchover in March 2012 was a major setback, but in the past 18 months UAL has made seemingly excellent progress in many areas — operations, customer service, product, technology and so on. Investors and analysts have increasingly asked: why is none of that translating into better financial results?

UAL’s inability to deliver has been all the more frustrating because of the enormous potential offered by this combine. United brought to the union a uniquely powerful global network. Continental contributed what was widely regarded as the very best leadership team in the industry. With such attributes, UAL should really be doing much better financially at this stage.

But Delta’s incredible progress since its 2008 merger with Northwest and AMR’s successful reorganisation and merger with US Airways (which closed on December 9) have also added to the pressures UAL faces.

At the three-year mark after merger completion, Delta was much further ahead than UAL — outperforming its peers in RASM, earning solid profits and paying down debt at a heady rate. 2013 will be Delta’s fifth consecutive year of $1bn-plus pre-tax earnings. Delta is now blazing the trail in rewarding shareholders; it began paying dividends this year for the first time in a decade and also launched a $500m share buyback programme.

American Airlines Group (AAL) is also surging ahead. Both AMR and US Airways have already been beating UAL in the profit margin league, and the combine can reasonably expect a relatively smooth labour integration process because the workers are fully onboard. One analyst suggested recently that anyone looking for “the next Delta” was more likely to find it in AAL than UAL.

What should a US airline to do in this kind of situation? Hold an investor day, of course. UAL held its first post-merger investor day on November 19 in New York. At the event the company sought to reassure the financial community that all was well and that it had a solid plan to cash in on the network and revenue opportunities, get costs in line and start rewarding shareholders from 2015.

The investor day message was extremely well received. UAL’s stock “shot through the roof to hit an all-time high”, as Motley Fool writers observed.

The financial community has historically tended to look at United through rose-tinted glasses. Both equity and debt investors like the global network and well-located hubs so much that they are prepared to give UAL the benefit of the doubt, provide all the funding it needs etc, even in circumstances where they would shun other airlines.

Of course, analysts have adopted a more measured response. While most have a “neutral” rating on UAL (as of mid-December), some have continued to rate the stock as a “sell/underperform”; because they feel that the shares are overvalued, because UAL has failed to deliver in the past and because Delta and (even) AAL pose less execution risk.

But, stock market considerations aside, does UAL now have a solid and realistic plan to retain its fair share of business and corporate traffic and start reducing the profit margin gap with Delta and AAL? Will it be in a position to start rewarding shareholders in 2015?

Why the below-par margins?

The consensus is that UAL mishandled the merger integration. With hindsight, analysts have made the point that the team led by Jeffery Smisek did not have hands-on experience in merger integration. That may help explain the IT switchover fiasco, though it is not entirely clear why it took so long to rectify the problems.

The IT switchover fiasco was discussed in previous Aviation Strategy articles (see July/August 2012 and January/February 2013 issues). The combine opted to switch to the smaller Continental’s systems. Dubbed the largest-ever aviation technology migration, it was a critical integration milestone that was supposed to drive significant merger synergies. Instead, things went wrong and UAL suffered extensive and prolonged operational and service issues.

The consequences were twofold. First, the problems alienated many customers. UAL lost valuable premium market share, weakening its revenue performance. Second, fixing the woes (increasing staffing levels, making more spare aircraft available, etc) caused costs to soar. UAL was already feeling CASM pressures because of the harmonisation of labour costs and the lack of ASM growth.

It was already clear by early 2013 that the operational investments to fix the 2012 problems had paid off. UAL’s on-time performance and other such metrics had improved dramatically. However, to ensure that things stayed that way, UAL has maintained higher than normal airport staffing and spare aircraft levels through 2013.

UAL has also invested heavily in product improvements, including flatbeds, satellite-based Wi-Fi, live television, new economy seats (for installation in the next few years). The aim has been to offer “the most” of just about everything, to beat competitors at every aspect of service. A new brand campaign, featuring a modernised version of the iconic “Fly the Friendly Skies” tagline (which today means “combination of service, technology and product enhancements”), started in September.

In the aftermath of the IT switchover fiasco, UAL also decided to put all its customer-facing workers worldwide through a new comprehensive training programme, which was 90% completed in October. The company hopes that “great customer service at United can become a powerful competitive differentiator”.

All of that sounds good, but it has added up to a lot of spending this year. “There is no question our costs are too high”, CEO Smisek noted in the third-quarter earnings call.

It has not helped that UAL has had to keep the two airlines’ flight operations separate. Full integration in that important area is now imminent, because the two pilot groups recently finally agreed on an integrated seniority list. But otherwise the labour integration process is nowhere near complete; although UAL has secured tentative joint agreements with its IAM-represented workers, it still needs to clinch contracts with two other big groups, Teamsters and AFA.

UAL insists that its so-called customer satisfaction scores have continued to rise (up 37% year-on-year in September), but that is not yet reflected in revenue trends. By its own estimates, UAL underperformed the industry by 4.5 points in PRASM in September.

The airline blamed its weak third-quarter PRASM performance mainly on yield management problems and competitive pressure on the Pacific, especially China. There was also a $55m headwind from the yen’s weakness. And analysts feel that UAL’s share of corporate travel is not recovering as quickly as anticipated.

UAL is the largest US carrier to China, operating more than twice the capacity of the next largest airline. As travel demand to and from China continues to soar, there has been a flood of competitive capacity on those routes. In the third quarter, industry capacity in the US-Beijing and US-Shanghai markets was up by 20%, and that trend is persisting into 2014. UAL saw its Pacific passenger revenues plummet by 11%, PRASM by 9.4% and yield by 8.4% in the third quarter, despite a prudent 1.7% reduction in its Pacific ASMs.

Of course, despite being a short term challenge, the Pacific and especially China routes will be a critical asset and a “key differentiator” for UAL in the longer term (more on its China plans below).

The management believes that after the efforts to fix and improve operational performance, customer service and the product, UAL is now competitive on all of those fronts — important for a global carrier that focuses on the high-yield segment.

To keep things in perspective, UAL has been profitable on an operating and ex-item net basis since the merger (annually and in most quarters, though a loss is expected in 4Q13). The third quarter marked the carrier’s highest level of quarterly profits since 3Q11. But the results obviously fall far short of what UAL is capable of (and should be) delivering.

When will UAL catch up?

At the investor day UAL outlined what it called a “path for increasing long-term shareholder value”. New plans to reduce costs, increase revenues and optimise the network featured prominently in the management’s presentation.

UAL is targeting $2bn of new annual cost savings by 2017. Half of those would come from improved fuel efficiency (new aircraft, winglets). The other half would come from increased productivity in other areas: reduced sourcing costs, better maintenance practices and inventory management, and lower distribution costs.

The $2bn cost cutting target may sound impressive, but it is actually only designed to keep unit cost increases below inflation (similar to Delta’s strategy). UAL still expects its ex-fuel CASM to grow in the 2014-2017 period. Next year’s increase is projected to be 1-2%, which would obviously be much better than 2013’s 6-6.5% increase.

In other words, without this new cost-cutting programme UAL could have seen some horrendous CASM increases in the next year or two, as further wage increases kick in and ASM growth remains constrained.

Capacity discipline is central to UAL’s strategy (as it is for Delta and AAL). Since 2008 United’s capacity has declined by nearly 2% annually. 2013 will see a 1.2% reduction in consolidated ASMs (including regional operations). The next four years are expected to see just 1-2% average annual growth in ASMs, with the consolidated fleet count remaining roughly flat at 1,250-3,000 aircraft.

UAL’s goal is to grow its pretax earnings by 2-4 times the current level over the next four years. Analysts say this is achievable, especially since the carrier is starting from a relatively low base.

The aim is to generate sufficient cash to begin allocating capital to shareholders by 2015 (through dividends or share buybacks, for example). That would be in addition to the existing goal of achieving a 10% ROIC.

Another new goal is to grow ancillary revenues by $700m in the next four years, to generate $3.5bn-plus from such sources by 2017, up from $2.8bn in 2013. UAL already generates more ancillary revenues than its peers, but it has apparently identified new opportunities, which it describes as giving customers new options, optimising pricing on existing products and making the products available through more distribution channels.

UAL is also further optimising its route network. First of all, it is eliminating unprofitable Pacific routes, such as Seattle-Tokyo and Tokyo-Bangkok, and down-gauging many other beyond-Tokyo sectors. The idea is to rely more on JV partner ANA to provide beyond-Tokyo connectivity. But UAL will be boosting service in more profitable markets such as Houston-Tokyo and launching a new San Francisco-Taipei route with 777s in March.

The intra-Asia contraction is actually part of a longer-term trend, reflecting growing demand for nonstop service. United’s intra-Asia ASMs have declined from 226m in 1999 to 156m in 2013 and will now fall further to an estimated 106m in 2014.

UAL intends to use the aircraft freed by the intra-Asia cuts to boost transatlantic flying; plans include a new Houston-Munich route and Dulles-Madrid and Chicago-Edinburgh seasonal services.

Of course, there will be interesting new expansion in US-Asia secondary markets, facilitated by the 787. Having introduced the 787 on the Denver-Tokyo route, UAL will use it to launch a three-per-week San Francisco-Chengdu service in June 2014.

As the 787’s first and so far only US operator, UAL will enjoy a “first mover” advantage in important future growth markets like Chengdu, which is China’s fourth largest city (14m population). UAL will be the first US carrier to offer nonstop service to China beyond Beijing and Shanghai.

China represents an enormous future growth opportunity. UAL is well-positioned to reap the benefits because it dominates the US-China market, operating 11 routes from five US gateways (compared to seven routes by all other US carriers combined) and 77 weekly departures (compared to 49 by other US carriers). UAL also offers the best connectivity in China (to over 90 cities) via Star partner Air China.

UAL continues to modernise its fleet by taking 737-900ERs and 787s and retiring domestic 757-200s. Year-end mainline fleet will total 693, nine fewer than a year ago. New deliveries will average 25 annually (somewhat higher in 2014-2015) and will keep the fleet count flat at around 700 in the “planning horizon”.

At the investor day UAL also sought to reassure the participants that its fleet spending will be “metered and disciplined” (it has been criticised for having higher capex than Delta). The 737-900ERs and 787s meet the ROIC maximisation criteria. But UAL has opted to defer A319/A320 replacement (and hence some $3bn of capex) by making a modest investment in “slimline” seats, larger overhead bins and suchlike. The result will be total annual capex in the $2.8-3bn range in 2014-2017, compared to Delta’s projected $2-2.5bn.

UAL and Delta have different approaches to aircraft investments, with Delta going for a higher mix of used aircraft. But the fleets, networks and other factors are also different. UAL executives noted recently that the new-versus-used decision is “really done on a fleet-by-fleet basis”.

UAL has reduced its total debt (including leases) from $25.9bn in 2006 to $19bn at year-end 2013 — a level its executives call “very manageable”. Debt maturities and lease obligations will average $1.2bn annually in 2014-2017, much less than in recent years.

But UAL hopes to get the total adjusted debt figure down to $15bn by 2017. It is obviously way behind Delta, which met its $10bn adjusted net debt reduction target earlier this year and now has a new $7bn target. If UAL had the same level of unrestricted cash in 2017 as currently ($6.7bn), the $15bn total debt target would translate into $8.3bn of net debt.

On the positive side, UAL has strong liquidity (18% of annual revenues), solid cash flow, a relatively modest pension burden ($1.8bn underfunded at the end of September) and $5bn-plus of unencumbered assets (including 90 aircraft). UAL’s credit profile is improving, as indicated by recent commentaries from Fitch and Moody’s.

The consensus view is that UAL will begin the process of closing the profit margin gap with its peers in 2014 and that in 2015 it will be in a position to start returning cash to shareholders. Because of the new cost-cutting programme, some analysts have nudged up their 2014 earnings forecasts.

But many analysts feel that, notwithstanding the likely improvement, UAL’s profit margins will still lag Delta’s and American’s even in 2015.